Be like Calpers: Dump your hedge funds

Hedge funds are a racket. They are great news for the people managing the funds, as they earn big, fat fees. They are usually a poor deal for the investors.

Just take a look at the case of the California Public Employees’ Retirement System, widely known as Calpers, the public-pension giant, which has just announced it is dumping its investments in these funds.

Calpers says its hedge fund investments earned 7.1% in the 12 months to June 30. For that performance, it paid $135 million in fees to the managers.

You know what? You and I are in the wrong business. An investment in the MSCI All World Equal Weight stock index would have earned 21.7% over that same period—and even someone who picked a random sample of world-wide stocks stood a good chance of beating the hedge whizzes.

The hedge fund guys pull their razzmatazz and their shtick, promising “proprietary algorithms” and a “secret sauce” and a “black box” and all sorts of other alchemy, and they make a fortune from fees. If I were better at being a con artist I’d go into business marketing my own fund, and then just quietly buy a bunch of stocks at random from New York to New Delhi, and then head to the islands for the year.

Over 10 years, Calpers says, their hedge funds earned a compound return of 4.8% a year. That’s enough to turn a $1 million investment into $1.6 million.

But over the same time the MSCI All World Equal Weight portfolio earned 10.44% a year. That’s enough to turn that $1 million into $2.7 million.

In other words, if Calpers had shunned hedge funds completely and randomly picked a big basket of stocks from around the world, chances are that their investment profits would have been nearly three times as great. (The bigger the basket, the more likely it is to approximate the overall return of the market.)

Gotta love that hedge fund expertise, don’t you? Wow, those quantitative analysts and their computer models are just so, so amazing.

Some people will argue I’m being unfair. A broad collection of stocks isn’t risk-managed, they’ll say. When you buy all those stocks, many of which are quite small, you’re getting higher returns but you’re taking on more volatility.

It’s hard to get a simpler risk-adjusted portfolio than that. You’ve got 60% of your money in stocks — split equally between the U.S., developed overseas countries, and emerging markets — and the other 40% in bonds, split between long-term Treasurys (in case of deflation or crisis) and TIPS (in case of inflation).

This is a common, garden-variety portfolio. There is no hindsight genius involved. The only activity required is rebalancing once a year, on June 30, to restore the equal weights.

How did it do? In the 12 months to June 30, while Calpers’ hedge fund geniuses were eking out 7.1%, this portfolio earned more than twice as much, or 14.5%. That’s according to an analysis by Thomson Reuters’ Lipper Horizon service.

Over 10 years, while the hedge funds were earning just 4.8% a year, this portfolio earned a healthy 8.6% a year—with minimal risk.

That’s enough to turn $1 million into $2.3 million. In other words, four Vanguard funds and one ETF from iShares (I used that because Vanguard’s own emerging markets fund wasn’t around for the full 10 years), bought online and simply rebalanced once a year, earned twice the profits of whatever geniuses Calpers found.

Longtime readers know I am not a complete fanatic for index funds and the “efficient markets” hypothesis. I believe the market can be wrong, even wildly wrong, for long periods—and often is. So I don’t believe a portfolio of random stocks or index funds is necessarily the best investment solution. But it’s pretty good if done right. It involves low costs, and immunizes you from the emotional challenges of investing. And it’s especially good for big institutions, as it avoids most value-destroying limitations and complications.

As a general rule, the simpler the investment approach the better you’re likely to fare.

Hedge funds typically charge you about 2% of your assets in fees every year, plus 20% of the profits, if any. (Note that the fund managers don’t share 20% of your losses, so they have a huge one-sided incentive to take big gambles; heads they win, tails you lose).

Those fees eat up huge amounts of any profit. Investors who think they are going to beat these high hurdles are probably living in fantasyland. Since 1928, U.S. stocks have generated compound returns of around 10%, and long-term Treasury bonds around 5%, according to New York University’s Stern School of Business. The typical balanced, 60-40 portfolio of stocks and bonds has therefore earned around 8% a year on average.

But if a hedge fund that invests in these stocks and bonds charges 2% a year in fees plus 20% of profits, then it will need to generate gross returns of 12% a year just to keep up.

In other words, your hedge fund manager will have to beat the market by a 50% margin—i.e., earning 12% when the market earns 8% — just to cover his fees. You won’t gain anything extra unless he beats the market by more than 50% each year.

Ridiculous.

I sometimes talk to people at big pension funds, and they are permanently being snowed by hedge fund managers, “funds of funds,” and “investment consultants.” Everyone wants a piece of the action.

Here’s some free advice that will almost certainly outperform what they are offering.

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